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Policy Choices and Resilience to International Monetary Shocks

Xuehui Han () and Shang-Jin Wei

Global Economic Review, 2014, vol. 43, issue 4, 319-337

Abstract: The well-known trilemma theory states that the nominal exchange rate regime plays a crucial role in a country's ability to pursue monetary policy that is for its domestic objectives independent from other countries' influences. In particular, a flexible exchange rate is required for an independent monetary policy. Capital controls may help a country with a fixed exchange rate to gain some policy space but the effect of capital controls is leaky and often short-lived. We revisit these conventional wisdoms and find no strong evidence supporting them in practice. In particular, a flexible exchange rate does not reliably deliver monetary policy independence, but capital controls do. This is consistent with the view that most (developing) countries dislike either depreciation or appreciation of their currencies, and therefore would choose to follow US monetary policy moves even if they are on a flexible exchange rate regime. In other words, to build resilience to international monetary policy shocks, capital controls are a necessarily component.

Date: 2014
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Handle: RePEc:taf:glecrv:v:43:y:2014:i:4:p:319-337